Asness met 'Grim Reaper' before fund rebounded

Richard Teitelbaum, Bloomberg News

Published 11:02 pm, Friday, October 8, 2010

Clifford Asness, who runs Greenwich-based AQR Capital Management LLC, one of the world's biggest hedge funds, says fellow fund managers gouge their clients by charging exorbitant fees for merely tracking the markets. He also takes a dim view of the administration of President Barack Obama, calling his economic team "Cossacks on a shtetl," a reference to the Russian cavalrymen who sacked Jewish villages in Eastern Europe in the 19th century.

"What kind of coward doesn't share his views?" asks Asness, 43, as he paces his Greenwich Plaza office overlooking Long Island Sound. "I believe strongly that the world is going on the wrong course."

Asness, who lives behind a stone wall in midcountry Greenwich, went the wrong way three years ago. From the start of 2007 through year-end 2008, AQR's flagship Absolute Return fund fell more than 50 percent -- the kind of drawdown that's often a death warrant for a fund. Firmwide assets tumbled to $17.2 billion in March 2009 from a peak of $39.1 billion in September 2007, according to AQR investors.

"I heard the Valkyries circling," joked Asness, who says he identifies with action heroes such as Captain America and Spider-Man. "I saw the grim reaper at my door."

Smart recovery

AQR survived. It did so by launching a campaign of diplomacy with its clients and offering a host of new funds and strategies. Asness's funds have recovered smartly. Though the Absolute Return fund's assets were down to $1.6 billion as of Aug. 31 from a peak of $4 billion, the fund rose 38 percent in 2009 and more than 10 percent through mid-September of this year, investors say.

As a quantitative investment firm, AQR uses algorithms and computerized models to trade stocks, bonds, currencies and commodities. Many quant funds got hit hard in 2007 and then again in the 2008 market crash.

"AQR has to fight against this current that's going against them," said Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a consulting firm in Darien. "They are one of the few quant firms that have managed to come back."

AQR's $1 billion Delta fund, opened in late 2008, returned 19.3 percent in 2009, an investor says -- beating Hedge Fund Research Inc.'s Fund of Funds Composite Index, which returned 11.5 percent. The fund was up 3.9 percent in 2010 through August versus a 0.3 percent loss for the Hedge Fund Research index.

Asset allocation

One version of AQR Global Risk Premium, a $3.9 billion asset allocation fund -- meaning it divides its investments across myriad markets -- surged 21.2 percent in 2009 and was up 17.2 percent this year through August, according to investors.

AQR also has been building a family of mutual funds for retail investors since 2008, with total assets in September of $2.3 billion. Three of them focus on momentum investing -- exploiting the tendency of securities to continue in their most recent trajectories. One invests in futures, and another bets on various kinds of arbitrage. Two trade foreign stocks. The latest, an asset allocation fund based on the Global Risk Premium fund's strategy, rolled out Oct. 1.

The firm markets the funds, which use quantitative models, through financial advisers.

Year to date through August, AQR has added $5.8 billion to its assets, which totaled $26.8 billion by the end of that month.

Suffering investors

Still, longtime investors in AQR suffered. The devastation of 2007 and 2008 gave the Asolute Return fund a negative record from its 1998 inception to its nadir in the market crash, according to a former employee. AQR declined to provide any fund returns for this article.

In early August 2007, AQR and some other quants found their programs had directed them into many of the same losing stock positions -- briefly costing them billions as markets short-circuited. Most funds quickly bounced back, only to plunge again in 2008 when stock, bond and commodity prices collapsed.

Research firm Lipper Inc. says quant funds fell in number to 240 in July from 374 at the end of 2005. From the start of 2005 through this June, investment firms actively trading U.S. equities using quantitative strategies had a cumulative return of minus 1.15 percent.

Those using fundamental techniques -- traditional stock picking based on companies' prospects and share prices -- had a cumulative return of 9.51 percent, according to EVestment Alliance LLC, an Atlanta-based research firm.

On Aug. 6, there was a rush to the exits. Stocks popular with quants collapsed as they sold, while those they were betting against soared as managers scrambled to cover short positions. On Aug. 10, markets rebounded. AQR Absolute Return, which had a peak-to-trough loss of 13 percent in August, finished the month down only 3.4 percent because it stuck with its positions.

The calamity of 2008 was far more wide ranging and enduring. The collapse of mortgage-related assets brought down the stock, bond and commodity markets globally. Absolute Return fell about 40 percent, according to investors. Now, Asness is working overtime to win back investors and make sure his algorithms perform.

Low fees

One reason some of AQR's funds attract investors is their low fees. The Delta fund offers investors an arrangement in which they pay a 1 percent management fee plus 10 percent of any profits it earns, versus the 2 percent and 20 percent typical of hedge funds.

AQR mutual funds charge as little as 0.49 percent, on a par with some of those offered by low-cost Vanguard Group Inc. Vanguard founder John Bogle says he's impressed.

"He's proved his point that he can do it at a reasonable cost," said Bogle, who's a fan of AQR research. "If I were a betting person, I'd bet he gives competitive returns."

Alaska endorsement

"His ability to communicate in front of trustees is phenomenal," said Jeff Scott, chief investment officer of the $36 billion Alaska Permanent Fund Corp., which invested $500 million with AQR in January.

On an August morning, Asness walks to his sun-dappled office windowsill and picks up a Captain America action figure. The hedge-fund mogul owns a panoply of action heroes, from the Hulk to the Silver Surfer, and the comic books that spawned them.

"I like to think of it as a much, much more affordable version of a money manager collecting art," he said.

Though the wisecracks never stop, Asness is at the same time a demanding boss.

And Asness admits to a temper: He's knocked his ViewSonic computer monitor to the floor on three occasions, though it never broke.

"Either they're building good computer screens or my punch isn't what it used to be," he said.

A plethora of funds

AQR manages some 65 funds of various stripes, and often tailors core strategies to meet client needs -- using more or less leverage, for example. The firm has adapted its models to trade in everything from the Polish zloty to Japanese bonds, to oil, gold and wheat. Asness says the myriad strategies and markets provide the extra safety that comes with spreading one's bets.

Example: AQR uses its models to run traditional long-only funds, seeking to beat a benchmark by a few percentage points while limiting risk.

"We really believe in diversification of all kinds," Asness said, adding that it especially helped during the meat grinder of 2008. "It did make it a lot easier to stay the course."

As he works to outsmart volatile markets, Asness continues offering opinions on everything from Broadway musicals to overhauling U.S. health care. Asness performs across all media, writing opinion pieces for newspapers and magazines, talking on television shows and at conferences and contributing to websites.

E-mail blasts

Asness sounds off most frequently in e-mail blasts to a personal network of friends, family and investors. One sarcastic example, from March, concerned a Senate move to create a federal office to predict financial crises.

"This is definitely going to work," he wrote. "No more bubbles. These geniuses will get it right. Promise. And all for a government salary."

Asness admits to a superhero complex. His favorite Marvel comic book character is Captain America, who gains strength with the help of a secret serum and whose shield can be used as an indestructible weapon. Asness has an image of the shield tattooed on his left arm.

`Frigging idiots'

In August, Asness was complaining about Obama's health-care law, which he calls socialized medicine, the increased powers Congress gave financial regulators and the tendency of commentators to blame banks alone for the crisis.

"Everyone dropped the ball on this; the public acted like frigging idiots," he said. "There were sins of individuals, sins of banks, sins of government."

Asness's views are not always predictable. He has praised Tea Party activists, blogging in March, "Your aggressive stand for freedom and small government has inspired the country." At the same time, he endorses the American Civil Liberties Union's campaigns to guard civil liberties.

AQR was buttressed by some key decisions during 2007 and 2008, Asness says. For example, the firm didn't panic and pull the plug on its models. "We believed in the models," Asness said. While that punished AQR in the sell-off, it left the firm positioned for the rebound beginning in March 2009.

"It's riding a statistical beast," he said. "Having a lodestone to come back to helps."

AQR has tried to keep its investors loyal by keeping them well informed of its strategies for battling the market turmoil.

No new rules

The firm didn't impose new restrictions on investor redemptions, as many funds did.

The firm did make some changes. Now, a big stock sell-off automatically will trigger systems that reduce leverage at various thresholds, cut back on risk and raise cash.

Like many quant firms, AQR is grounded in the efficient market hypothesis, or EMH, promulgated by professor Eugene

Fama of the University of Chicago, who was Asness's thesis adviser. Fama, 71, and his adherents say that the stock market is effective at digesting the available information about an asset and setting the right price for it.

Not perfect

Asness said he doesn't believe any market is perfectly efficient.

"We aren't believers in the extreme form of the efficient market hypothesis and shouldn't have to defend it," Asness said. "EMH says `prices reflect all information,' and I think the tech crash and the real-estate bubble culminating in 2008 were real blows to that idea."

AQR's business, in fact, is to find inefficiencies in the markets and profit from them. Fama and Kenneth French, who now teaches at Dartmouth College, in 1992 published research showing that stocks with high book values relative to their prices outperformed those with low book values. The difference between the two is known as the value premium. The book value of a company is its net worth.

The same research found that small-capitalization stocks outperformed large caps.

Value premium

Quants such as those at AQR have found ways to apply the value premium to different markets and asset classes, such as currencies and bonds -- or whole countries. Asness and colleagues might add up the market valuation of stocks in France and Germany, compare them with the earnings or book values of the listed companies and conclude that one of the countries' stocks are undervalued.

Another variable that generates a premium is momentum --the tendency of a stock's price to continue upward if it is rising and downward if it's falling. Asness, in his 1994 dissertation, was among the first to show the existence of a premium tied to momentum, Fama says.

The value and momentum premiums drive more than half of AQR's returns, Asness says. Another model AQR uses asserts that the stocks of companies that are reducing their share count tend to outperform those of companies increasing it.

"We think they all make money more often than not," Asness said.

Lawyer's son

Born in Queens, N.Y., Asness may have inherited his entrepreneurial streak from his mother, Carol, who ran a medical education firm. His father, Barry, was an assistant district attorney in Manhattan. Asness's younger brother Bradley would follow in their father's footsteps; he took up law and is now general counsel at AQR.

"He's 6 foot 2, has all his blond hair, and I am bitter," Asness joked.

Cliff Asness is 5 foot 10 inches tall and weighs 200 pounds. He is bald with a graying beard.

Asness wasn't an academic star at Herricks High School in New Hyde Park, N.Y.

"I had a mediocre record in high school," Asness said. "I was desperately trying to get girls interested in geeks."

His destiny, according to the 1984 yearbook: "Rich."

Summa cum laude

Asness earned two bachelor's degrees at the University of Pennsylvania, one from the Wharton School and the other from what is now the School of Engineering and Applied Science, graduating summa cum laude.

"I believed in diversification even then," he said.

After a summer job at Goldman Sachs, he signed on for a one-year research job in 1992. In 1993 and 1994, the doctoral candidate found himself struggling to complete a 150-page thesis while logging 80-hour weeks for Goldman. In 1994, the investment bank hired him to build a quant research department.

In addition to building trading models, the Quantitative Research Group crunched numbers and drew charts to help guide the bank's traditional stock pickers and other managers. Asness also started what was then a small hedge fund for Goldman called Global Alpha -- which would grow to $11 billion in assets by 2007.

Under Asness, Global Alpha scored gains of 111 percent in 1996 and 42 percent in 1997. He grew frustrated with his other duties.

"We thought it was crazy that they wouldn't let us focus on investing alone," Asness said.

Two sets of twins

Asness and partners decamped from Goldman to start AQR in 1998. In 1999, Asness married Laurel Fraser, a former Christie's International saleswoman, who before they dated had been his executive assistant at Goldman. They are parents of two sets of twins, born 18 months apart.

AQR started with $1 billion, Asness says. It began trading in August 1998 -- when the bubble in Internet and other technology stocks was in full bloom. AQR followed its models, betting against expensive stocks and buying cheap ones. That meant Absolute Return hemorrhaged money until the market turned against tech in March 2000.

"We began with $1 billion and through hard work and acumen turned that into $400 million," Asness joked.

The founders toured the world, trying to persuade investors that the tide would turn. In 2000, Asness penned a paper called "Bubble Logic," in which he picked apart the arguments supporting sky-high technology stock valuations.

"When fallacies rule the land, somebody has to point out the naked emperor," he wrote.

Market turn

In March 2000, the market turned and Absolute Return began making money. The fund finished 2000 up 16.7 percent, investors say. The Nasdaq Composite Index lost 77.9 percent of its value from March 2000 to October 2002. From there, AQR flourished, with assets rising to $12 billion in 2004, when the firm moved to Greenwich.

A key lesson of 1998 to 2000 was replayed less than 10 years later.

"No strategy is so good that it can't have a bad year or more," Asness said. "You've got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen."

The firm also has redoubled its effort to develop new strategies for boosting returns and improve existing ones. The Delta fund is one result. Drawing on years of analysis, the fund is based on the notion that some of the investing techniques used by hedge funds, such as merger and convertible bond arbitrage, aren't as sophisticated as they're cracked up to be.

AQR's research showed that with the right formulas programmed in, the buying and selling of stocks and bonds for merger and convertible bond arbitrage could be automated. And that's what the Delta fund is: a kind of systematic hedge fund using multiple strategies.

"It's sexy in a wonkish sort of way," Asness said.

Balancing risk

The Global Risk Premium fund is another example. Research showed that pension funds that use traditional, balanced asset allocation formulas -- say, 60 percent stocks and 40 percent bonds -- are unbalanced in terms of risk. That's because stocks, which are much more volatile, may account for 85 percent to 90 percent of such a portfolio's risk.

The Risk Premium fund puts money to work in a variety of asset classes -- stocks, bonds, commodities and others -- to spread risk more evenly. The amount of volatility a pension investor wants in order to get to a desired return is adjusted with leverage.

Asness and colleagues say they're tweaking formulas at the fortified Absolute Return fund so that it can return to its former prominence in the firm.

Post-crash blues

Around the developed world, expectations for future investment returns have withered after the financial crisis and the drawn-out recession. Asness realizes that AQR won't soon return to the fat margins of pre-crash days.

"The whole industry is less lucrative than it used to be," he said.

How will AQR define its success in an era of tempered hopes? More assets? Higher profits? Asness -- father of four, self-declared family man -- gives an answer he knows will get him in trouble at home.